Japanese equities: Will the momentum carry into 2018?

After underperforming the world’s equity markets for most of 2017, Japan finally woke up in the fourth quarter – the Tokyo Stock Price Index (TOPIX) surged 12.8 percent from October to early January, ranking Japan as the best-performing stock market worldwide during the period. This followed three quarters of underwhelming equity gains, during which TOPIX rose just 6 percent, placing the market close to the bottom of the global performance ladder.

Two elements in particular helped to spark the recent rally. The first was the ruling Liberal Democratic Party’s landslide victory in the national election in October, as it increased international investors’ confidence in Japanese stocks; foreign funds hold substantial sway over the country’s equity market. Before the election, Prime Minister Shinzo Abe’s paltry public approval rating led many to speculate about the fate of his leadership and thus Abenomics’ potential demise. This shook foreign investors’ confidence, as they view Abe and his economic policies as Japan’s best shot at recovery.

The second and more important factor was better-than-expected earnings in the September quarter despite the relatively stronger JPY (versus the US dollar). This proved two things: first, that FY17 earnings will likely be higher than initially projected; and second, that the historical inverse correlation between corporate earnings and the USD/JPY pairing has loosened. Earnings typically sink on a strong Japanese currency, and rise on a weak yen, due to Japanese companies’ high exposure to export markets. But the strength of the global economy, especially in key regions like China and the United States, helped to overcome this trend.

So will this momentum last in the new year? UBS expects global economic growth to remain buoyant at 3.9 percent in 2018, arguing for another solid year for Japanese corporate earnings. However, while benign global economic conditions will certainly help, there are other factors at play that should tilt the scales against a repeat performance.

A foremost reason is China, Japan’s largest trade partner. The Chinese splashed on new machinery and manufacturing equipment last year, amid the robust macroeconomic climate, to upgrade their industrial capacity and boost their new-economy output. This in turn juiced the profits of Japanese businesses, many of whom specialize in making such high-end products.

But in 2018, we expect Chinese economic growth to slow markedly (to 6.4 percent from 6.9 percent in 2017) and Chinese companies to scale back on corporate capital expenditures, effectively ending this tailwind for Japanese companies.

Other factors that could hurt earnings and/or share prices include the intensifying labor shortage, which should increase wage pressure, and the Bank of Japan’s quantitative easing policy, which we expect to become less accommodative later in the year.

So no, we don’t expect the recent momentum to last. In fact, we expect earnings to start slowing by the start of second half of 2018 and to fade almost entirely by the end of the year. While we recently upgraded our earnings forecast for FY18 from minus 2 percent to positive 1 percent, our target is still far below consensus’ expectations (7 to 8 percent) and implies a sharp slowdown from FY17 (est. 12 percent).

Nonetheless, we still see various opportunities in select sectors and stocks. We like Japanese financials ahead of our expectation for higher interest rates later in the year, and stocks with high dividend yields. We also think companies that are committed to meeting environmental, social and governance criteria are poised to outperform over the long run.

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